Cyclical and Turnaround Stocks: There Is A Lot Of Value In This Market: Part 5

This article represents the final installment in our “There Is A Lot of Value In This Market” series. Links to parts one through four can be found here. In some ways, this article represents prima fascia evidence supporting some of our main hypotheses. First of all, this article will clearly support the notion that not all common stock are the same, and therefore, they should all not be painted with the same broad brush stroke (generalities or opinions). The examples in this article will clearly illustrate just how different individual companies are. Therefore, this further validates the notion that each company should be evaluated on its own individual merit, thereby validating the concept that it is a market of stocks and not a stock market.

Furthermore, this article will present a significant challenge regarding how to properly calculate fair valuation on cyclical or semi-cyclical companies. The real issue with cyclical companies is having the confidence regarding what future earnings might be. In other words, even when consensus estimates are positive, the prudent investor must ask themselves – how long can it last? Moreover, the answer can vary dramatically from one company to the next. In other words, depending on exactly how cyclical the company is and how cyclical its industry is, will ultimately determine whether earnings are to continue rising for a while or suddenly fall out of bed. This is the treachery with investing in cyclical stocks. Sometimes they can be very rewarding, and sometimes they can cut the legs right out of your portfolio’s performance.

Turnaround Stocks: High Risk or High Reward?

The first equity classification we are going to look at we will define as turnaround situations. This implies a company that, after struggling with significant operating issues, is set to turn its business around. It’s important to state, that these are typically not your everyday buy-and-hold kind of stocks. Instead, these tend to be higher risk opportunities that will often only warrant a short-term holding. To put this into perspective, these are the situations that offer a high degree of profit potential, but simultaneously at a high degree of risk. Consequently, they would not be for consideration as a core holding, that might represent opportunities for what some investors like to call their play money.

Is Goodyear Tire & Rubber (GT) A Turnaround Opportunity?

Our first example will be Goodyear Tire & Rubber. A quick glance at the 20-year F.A.S.T. Graphs™ on this company tells us a great deal about its business instantaneously. For example, we can see that it has been very challenging for this company to maintain any type of profitability. We see that profits began collapsing in the late 1990s, and we also see that price followed. This validates the idea that earnings determine market price in the long run. Another important perspective that this graphic illustrates is how the company quit paying its dividend in 2003. The light blue shaded area indicates dividends, and visually we see that they disappear.

Since 2003 we see a very cyclical and spotty record of earnings volatility. This begs an important question that a prudent investor should ask. How much can I trust this company’s future earnings potential? In other words, forecasting future earnings for this company would be very difficult, to say the least.

A quick look at the long-term track record of this company with deteriorating long-term earnings results validates our notion that this is not a buy-and-hold candidate. If you are an investor that believes that the strategy buy-and-hold is dead, then this company could be your poster child. As the performance report reveals, this company has destroyed shareholder value since 1994.

Yet, and on the other hand, after a company has generated very weak results, it can often be very easy to generate very high future growth if the business has any earnings power at all. Therefore, our next graph on Goodyear shows an extremely high rate of earnings growth simply because earnings are coming off of such a low base. But, and this is a very important but, we believe this also represents a classic example of how statistics, or put another way, a representation based on just numbers, can be very misleading. Because, it is a fact that since 2010, Goodyear has generated an extraordinary earnings growth rate in excess of 45% per annum.

Furthermore,an observation that we have noticed after reviewing thousands of examples, is that future earnings estimates will tend to have a built-in bias based on recent results. In the case of Goodyear, the consensus earnings estimates of nine analysts reporting to Capital IQ estimate five-year earnings growth of 46.3% per annum, a number that is very close to what it has achieved over the past four years or so.

Microsoft MSN Goodyear Tire Forecast From Zacks

A cross-check look from another source corroborates what Capital IQ analysts are forecasting. Below is a screenshot from Microsoft MSN illustrating the consensus five-year estimated earnings growth rate on Goodyear by seven analysts reporting to Zacks. Interestingly, the estimate is identical to Capital IQ. However, it seems too much of a coincidence that this number mirrors recent history so closely to not consider it biased.

General Electric (GE): A Turnaround That Is Succeeding

When we look at the long-term operating history of General Electric we see a company that was once a classic example, or even the epitome, of a blue-chip dividend growth stock. However, since the company had built in a very large financial division, everything changed as the financial industry instigated the great recession of 2008. As we can clearly see, General Electric’s earnings collapsed during 2008 and 2009. However, earnings growth has been recovering since, as we will see with our next graphic.

Since calendar year 2010, General Electric’s earnings have staged a very respectable rebound averaging growth of 12.3% per annum. It’s also very important and useful to note that stock price has followed suit and has closely tracked the resurgence in earnings growth. Also, notice that the great recession that actually brought General Electric’s stock price in line with fair value based on these resurging earnings.

As a result of the turnaround in General Electric’s business, investors who had the foresight to buy the company expecting a turnaround were well rewarded. After the dividend was literally cut in half in 2009, it has once again begun growing again. Moreover, since share price has closely tracked General Electric’s recovery earnings, capital appreciation of 16% per annum has been exceptional. Add in the once again rising dividend and shareholders have enjoyed an 18.8% rate of return since the beginning of calendar year 2010. This validates the notion that turnarounds can represent exciting and profitable opportunities.

Cyclical Stocks: A Roller Coaster Ride To Riches Or The Poor House?

Cyclical stocks are different than turnarounds. A cyclical stock is a company that has a legacy of its business routinely going through cycles of boom or bust. A true cyclical company can provide investors great profits during the good times, and conversely destroy a portfolio’s performance during the bad.

Textron Inc. (TXT)- When It’s Good It Is Very Good, When It’s Bad It Is Very Bad

Let’s examine the long-term historical record of Textron Inc. (TXT) since 1994 to see a quintessential example of a cyclical stock in action. You will see that when Textron’s earnings are strong and growing, stock price follows suit. Conversely, during the times when earnings are falling off a cliff, so do stock prices. The point being that if you can pick a stock when earnings are poised for an intermediate term advance, there are great profits to be had. However, the hat trick is finding when to get out before the music stops. Although that is easier said than done, timing does not have to be perfect, but it does need to be reasonably responsive. In other words, waiting around too long validates the old adage “he who hesitates is lost.”

In order to get a perspective of how profitable a cyclical stock can be when things are going right, our next graph looks at Textron from calendar year 2002 through calendar year 2007. This was a six-year time frame when earnings growth was averaging 28.5% per annum, and when the company’s beginning valuation was in alignment.

Therefore, shareholders in Textron during these profitable years were highly rewarded. Capital appreciation generated 22.9% per annum compounded return, and the addition of its dividend, paid but not reinvested, increase the annual rate of return to over 24% per annum.

On the other hand, if you own a cyclical stock during the bad side of a cycle, like the last six years have been for Textron, it can be a devestating investment. The following graphic looks at Textron since the great recession of 2008 where we see the company’s earnngs collapsing and stock price following it down. However, since calendar year 2010, Textron’s business and stock price have been on a recovery trajectretory.

It’s amazing what a difference owning a cyclical stock during the bad times can make. The following performance since calendar year 2008 (the great recession) shows that shareholder returns were abysmal. Both capital appreciation and dividend income were negative during this period.

Currently, the consensus of 14 analysts reporting to Capital IQ, expect Textron to once again grow earnings in excess of 28% per annum. If this truly is, as Yogi Berra would say, déjà vu all over again, then this may be a good opportunity to invest in Textron.

A cross-check with Microsoft MSN corroborates that the consensus of analysts reporting to Zacks also expects similar five-year earnings growth at 26% per annum. Although this instills some confidence that there is at least a reasonable consensus, let us remind you of the warning we expressed with our Goodyear Tire example above. In other words, at the end of the day it’s always up to us to determine whether or not we think the estimates are reasonable and achievable or not. Our future returns will be a function of what the future investment results turn out to be adjusted for valuation.

Microsoft MSN Textron Inc. Forecast From Zacks

Manitowoc Co. (MTW) and Caterpillar (CAT)

Our final two examples review the historical records of Manitowoc Co., a leading manufacturer of building cranes and a major player in food service equipment, and Caterpillar, who needs no introduction. Although both of these companies would clearly meet our definition of cyclical, the earnings and price correlated graphs on each show that they are different, yet in some ways the same. Both graphics illustrate that these companies are sensitive to economic cycles, you can clearly see how profits rise and fall with the economy. But even more importantly, you can clearly see how stock prices logically react to those same cycles.

Summary & Conclusions

As we conclude this series of articles, we hope that readers have at least been given the perspective that not all common stocks are the same. More importantly, we also tried to illustrate that it is not the stock market that ultimately drives the returns of individual companies. Instead, it is the individual operating results of each respective company that will reward shareholders in accordance with the business results that individual companies have achieved on their behalf.

Therefore, the final message is to encourage investors to quit worrying about what the market might do or what the economy is going to do. Instead, try to identify really great businesses where you like the management and the price. Long-term investment performance will follow long-term operating performance. Try to keep your emotions in check, try to filter out all the noise that you are bombarded with every day, and try to make intelligent investing decisions on facts. Because, as we have often stated, the problem with following the herd is that your ultimate destination is the slaughterhouse.

Disclosure: No positions at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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